Monthly Archives: September 2010

This article enlightened me—a novice in the investment world—to a few things:

1)    In regards to earnings, companies release either/both of two figures to the public: 1. “as reported earnings” which conform to GAAP, and 2. “operating earnings” which exclude one-time items (and allow management a bit more flexibility in what is reported).
2)    Historically, the gap between “reported” and “operating” earnings has been wide, illustrating a fundamental and philosophical divide between how FASB and businesses define earnings. Why can’t the two camps figure out one standard for reporting earnings? Subjective judgments from company to company make them non-comparable over time.
3)    Regardless of which camp you’re in, two earnings figures translates to investor confusion. So, don’t make an investment based on “earnings,” unless you’ve first read the financial statements and determined exactly what those “earnings” report.

On the businesses side of things, “operating earnings” are calculated to the exclusion of one-time events, presumably reflecting a more accurate account of “business-as-usual” earnings.  The article points out that since 1995, “operating earnings” have topped GAAP earnings by an average of $2.47 per share—showing that the “business-as-usual” outlook has historically been brighter than what has actually occurred in any given year (how optimistic!). But recently (June 2009), the gap between those earnings figures narrowed to $0.31.

The author interprets this narrowing as a sign of market stability. I speculate that a major cause for this narrowing is investor skepticism (a mark of instability). On the heels of the Madoff scandal, and in response to public outrage, I think Wall St. reported earnings more conservatively, and closer to their GAAP earnings, in the name of transparency and in attempts to restore investor confidence. Honestly, I think that we’ll need to deem one consistent, less prone-to-manipulation method for reporting earnings (among doing many other things), to restore my confidence. But in the meantime investors, it pays to mind the GAAP gaps.

“Investors, It Pays to Mind the GAAP Gaps”, is a great article that shines a light on the increasing gap between non gaap operating earnings and gaap conforming operating earnings among companies within the Standard & Poor’s 500.  Before expanding on the significance of this gap, first, let me briefly explain the reasoning behind announcing non gaap operating earnings along with gaap earnings.  Management teams inside of corporations as well as some analysts believe that non gaap operating earnings can be a better indicator of the performance of a corporation.  This alternative method of reporting operating earnings removes any one-time charges or any one-time gains as opposed to gaap conforming operating earnings which account for the impact of one-time items.  Executives and analyst will argue that the impact of these special items skews or blurs a company’s true financial picture. 

The Microsoft case is a great example of this occurrence.  Microsoft in the quarter ended June 30^th 2007, reported gaap operating earnings of $4 billion while also providing investors with non gaap operating earnings of $5 billion.  The difference in the two figures is related to a $1.06 billion Xbox warranty enhancement charge.  According to management and probably most of the analyst community, this charge is a one-time occurrence and is not expected to reappear.  Looking at this example it is understandable why some investors would prefer non gaap earnings as they believe it is a better depiction of Microsoft’s operating performance for the quarter. 

The article’s author, Mark Gongloff, raises a number of legitimate concerns.  When looking at the past 14 years, the gap between gaap and non gaap operating earnings numbers has risen by $2.41.  When the averaging the gaps between these earnings over the past 10 years to eliminate any spikes or dips, non gaap operating earnings were almost 24% higher than gaap earnings.  After reading the article, I thought to myself, “What does this signify?”  Why has the gap between gaap and non gaap earnings grown so much over the last decade or so?  Is it simply that executives are managing today’s corporations more differently than before or could there be an underlining cynical reason that’s causing one-time charges to increase when compared to one-time gains.

A critical look inside the Microsoft case might provide some answers to these questions.  As mentioned, Microsoft took an Xbox related charge of $1.06 billion.  Part of the charge was related to warranty claim payments to customers who bought the Xbox, experienced problems with the device, then turned to Microsoft for a fix.  Microsoft, in an attempt to ensure customers who were interested in the Xbox that it stood behind its product, enhanced the existing warranty policy.  Thirty five percent of the charge was also “attributable to inventory valuation adjustment” or, in other words, Microsoft looked at its Xbox and realized that some of its chips did not work properly and had to replace them. 

It is very possible that when Microsoft’s management team was setting the budget for its latest innovative product that the team was more interested in supporting Xbox’s profit margin, therefore, cutting cost and corners.  This cost cutting strategy might be the reason that Xbox did not perform as expected by customers thus forcing Microsoft to pay high warranty claims.  It would not be the craziest idea to think that executives would push today’s cost to tomorrow in the form of one time charges to help please Wall Street and most importantly to help pay for the new home in Hawaii.  This strategy and others that compromise product quality across America’s industries might be just one reason for the increasing gap between gaap earnings numbers and non gaap earnings numbers.

I believe the article “Investors, It Pays to Mind the GAAP Gaps” does an ok job in explaining why there is a difference between GAAP numbers and Non-GAAP numbers in terms of operating expenses for income statements for different companies. According to the article, many companies will have higher Non-GAAP numbers than GAAP numbers because many companies will not include one time costs/revenues in their income statements in the Non-GAAP numbers. Of course the reason for doing this is because they want their investors to see what their “normal” operating earnings usually are under normal circumstances. I say the article does an ok job because it doesn’t really say why the Non-GAAP numbers have been higher on average for the past 10 years, even when we weren’t in the recession. It is highly unlikely that more one time costs have occured than one time revenues every single year. I believe it is always higher because companies will try to be as optimistic as possible, especially when things are looking bad. This is evidenced in the article when it states that companies with a larger difference tend to do worse in the long run.

Additionally, the article goes on to discuss how over the past few years, the recession has caused the gap between GAAP and Non-GAAP numbers to increase because due to the recession, more bad events have occurred than good ones. Therefore one time losses have increased and one time gains have decreased. However, according to the second quarter numbers, the difference between GAAP and Non-GAAP decreased significantly. I believe this could be for three reasons: Either the economy is recovering so there is less incentive to inflate numbers, the one time bad events are no longer one time events, but have been continuously recurring, or people are starting to realize that heavily inflated Non-GAAP numbers is actually a sign of weakness. Personally, I think our economy could get a lot worse, but for the time being it has been somewhat stable, which has decreased the number of one time costs and decreased the need for companies to feel like they have to inflate their numbers in order to have a better image. Regardless of why, it is still important to follow both numbers because in general, an analyst may want to leave out extraordinary events when projecting a companies future growth. However, I also believe it’s important to take one time factors into account when making investments because although they are very rare and extremely difficult to predict, they DO occur, and if one is prepared, he/she can make a healthy profit or in some cases, save a lot of money.

Although Accrual Based Accounting methods bring with them great benefits like allowing the management to exercise better management of assets, gives a fair description of the financial position of a company at any given point of time and more importantly in today’s times of complex business transactions allows them to be recognized fairly. It had allowed managers the ability to present to shareholders a much better picture of how the company is doing over a long period of time.

The author touches upon how the introduction of “estimates” complicated and increased the problems the industry already faced. Since Lanxin and Anelisa have already touched upon the points pertaining to how estimation can be sometimes misused by corporations to manipulate and misreport earnings and how its is necessary for the investors to be careful and conduct their own research before making any investing decisions.

I would like to elaborate and talk about a topic that the author briefly mentions about “Fair Value Accounting.” I would like to elaborate about this form of accounting and how it has over the last few years been come to blame for one of the biggest economic crises we have seen in our lifetimes.There are proponents who blame fair value accounting for our current economic crisis since it valued a lot of the assets that financial institutions held to pittances. Detractors of this form of accounting suggested that it led to many banking institutions failing and which further led to fall in the value of assets.

However not marking to market would also mean that institutions and corporations were in essence trying to shy away from the problem at hand until it got manageable/ or probably worse and is not often the best approach. The solution to this issue could be a middle way out and an accounting practice that would segregate how assets are valued and carried on books based on their purpose.They could also be categorized based on the possibly predetermined length of investment and purpose of investment. But panning either method of accounting is not a solution to the problem on our hands and the FASB in collaboration with governments and corporations should work towards coming up with the most effective and transparent accounting practices.

I believe Accrual Based Accounting is an inevitable accounting practice in today’s times of complex business arrangements. But addition of Footnotes and specific directions on Assumptions made by management of corporations and increased investor awareness will make the reporting system foolproof and the markets more efficient.